Drawing Upon Examples Of Depository And Non-Depository Institutions, Explain The Process Of Financial Intermediation And Its Importance In The Provision Of Liquidity In The Financial System
Every economy and financial market has its own shortcomings in regards to employment of funds. The prosperity and equilibrium of a financial market is determined by the allocation of surplus. In a huge market, most participants are unaware of others, and therefore it is crucial to have an intermediary system that will reallocate funds from the surplus areas to the places where funds are actually in demand. This gives mobility and liquidity to financial markets. Among all other participants, the role of financial intermediaries is played by the depository and non depository institutions. While the depository institutions borrow money for the surplus possessing individuals and businesses to lend money to others in need, non depository institutions don’t take direct borrowings but use other methods to gather funds and lend them to borrowers. The function of both kinds of the institution is the same- the mobilize funds and offer liquidity to financial markets.
Need for Financial Intermediation: The function of financial intermediaries is excessively critical for the economy, as well as for financial market. Financial intermediation is essential for the productive use of surplus funds. For the financial market, it helps to distribute the funds and aids the process of optimum use of surpluses. For the economy, it creates greater demand for services and goods and helps in generation of incomes and employment opportunities. In the past few years, the importance of financial intermediation has doubled in all small and large economies as it acts as channelized energy for entrepreneurial activities.
Benjamin M. Friedman stated in his studies, “The principal rationales that give rise to financial intermediation are benefits of size and specialization, the diversification of specific asset risks, and the pooling of even broader classes of risk. Each is a significant factor in accounting for the U.S. economy's reliance on intermediation. In addition, since World War II a further important factor has been the economy's continual shift away from government debt toward the debt of private nonfinancial entities including individuals and businesses.”
The process and concepts of financial intermediation: It is a common question whether there is a need for financial intermediation. In precision, every saver is not willing to lend voluntarily as there are numerous risk factors involved in the financial market. Lenders often need assurance that their investments and lending will not lead to losses. Intermediaries act as a common platform between these lenders and the ultimate borrowers. Mentioned below are some short risks that are covered with financial intermediation.
There are numerous situations in the financial markets which lead to non-payment of dues. While a borrower may have positive intentions to repay his dues and installments, there are might some temporary hiccups on the way. These risks are reduced by financial intermediaries as they can use their channels to compensate such loss-win situations.
Credit risks are one of most common risks for lenders. This arises out of many factors like dishonest of borrower, financial doom, and lack of incomes. Such situations can be downright tough for the small lenders who are concerned about their smallest investment. Financial intermediation by an institution can help to balance this risk by offering guaranteed investment incomes.
This is probably one risk that small lenders cannot escape with direct finance. In case, the market rate of an investment lowers, borrowers may ask for a reduction, or in the vice versa situation, they may refuse to pay a higher rate. Financial intermediation helps in reducing these risks.
Many researchers and analysts have written about the role of financial intermediaries in different lights. There are more than a few known roles of financial intermediaries, which are often considered as their direct contributions. There are many investors and participants in the market who like to take advice from a financial intermediary before they take the plunge of direct investment. As such, intermediaries do recommend CIS investments to investor, which further broadens their horizons. There are numerous regulatory bodies working in financial markets, and most of these implement certain rules of conduct on intermediaries. These rules are not just restrictive, but give ample power to institutions for conducting fair business. With completion mounting up every day, institutions, both depository and non depository, need to ensure that they act smartly in their circle and increase the profits. This particular smart play these intermediaries result in development of fairness in the market, which is another added advantage. Also, it can be observed that these institutions do have a great hold on the economy of a country. While their participation is a boon to the money movement and funds, their refusal to perform and participate can stagnate an economy. It can be observed that most doom periods in the history of large economies have occurred due to certain intentional or unintentional role of these institutions. In many studies of close and open markets, the roles of financial intermediaries have always created debate and questions.
Depository institutions and their role in financial intermediation: When it comes to financial intermediation, the role of depository institutions is paramount. A depository institution is financial body that accepts and invites deposits from individuals and businesses and invests the same in other lending businesses. Indirectly, they help in intermediation of funds as they use the financial surplus of a market and use the same in areas where these funds are actually needed. The simplest depository institution is a commercial bank. It accepts deposits from small and commodious savers and lends the same to others. Such institutions and banks help in retaining liquidity in the economy and reduce the stagnancy of the financial market. in their paper on financial intermediation, Gary Gorton & Andrew Winton stated the importance of banks in particular, “As the main source of external funding, banks play important roles in corporate governance, especially during periods of firm distress and bankruptcy. The idea that banks “monitor” firms is one of the central explanations for the role of bank loans in corporate finance. Bank loan covenants can act as trip wires signaling to the bank that it can and should intervene into the affairs of the firm. Unlike bonds, bank loans tend not to be dispersed across many investors. This facilitates intervention and renegotiation of capital structures. Bankers are often on company boards of directors. Banks are also important in producing liquidity by, for example, backing commercial paper with loan commitments or standby letters of credit.”
According to the data available for 2005 by FDIC on its industry analysis of depository institutions, there are more 9000 depository institutions in the United States that can act as financial intermediaries. They are lifelines to the financial market and are crucial for businesses and individuals alike for their daily and annual profit generation. Apart from fund allocation and optimization, these institutions minimize all kinds of risks, including those mentioned above.
Non- Depository institutions and their role in financial intermediation: Another type of financial intermediary is non depository institutions. These institutions are functionally different from depository institutions as they do not accept direct deposits from savers. A non-depository institution is the one that pools money from individuals and businesses by way of contributions, premiums and selling of securities and lend the amounts to other parts of the market where money is in demand. Just like depository institutions, these institutions do invest money in different sectors but avoid accepting direct deposits. In fact, in the United States, the role of Financial Intermediary was first played by a non-depository institution, much earlier than depository institutions.
In a statement in FT, David Roche points the significance of non banks in US. He mentioned, “The Federal Reserve has belatedly recognized that investment banks, hedge funds and other non-deposit-taking financial institutions are as vital as banks to both the financial and “real” economies. The Fed is lending them massive amounts of capital through newly created facilities. It is right that central banks should be able to do so; NDFI’s create more “asset money” than banks but are much riskier institutions.”
The function of such institutions in financial intermediation is to channelize and muster finance from the surplus sector to the needy sectors. They act as a bridge between lenders and borrowers and remove and diminish many risks that one would find in these markets with high end volatile risks. While there are no direct investors, borrowers can be at mental peace that the rates of interest will not fluctuate unconventionally and payment structure will not change without notice.
Almost every country on the globe has witnessed the growth of economy due to financial intermediation. In the year 1977, Sri Lanka introduced economic liberalization policies for achieving a greater growth and molding its economical structure. It was quite obvious that there would have been serious changes in the economy as the concepts of liberalizations were still being tested by many countries of the world. Studies conducted showed some significant relation between financial intermediation and growth. A study was conducted on the primary base of endogenous growth theory. It is pertinent to mention here that endogenous growth theory measures economic growth related with trade and financial liberation, with other investment factors relation to physical and human capital. Amongst all other findings, the most notable one was in relation to depository institutions which acted hugely in financial intermediation. Commercial banks and their activities led to a positive and worth mentioning impact on per capita income.
In the recent times, the Federal Reserve has documented the value of investment banks, insurance companies and all other non-depository institutions for financial markets and real economies. It has been found that NDFI’s make asset money which is larger than commercial banks. On the flip side, these institutions are highly risky. In the United States, investment banks and hedge funds constitute half the size of the market of commercial banks in their balance sheets. These institutions work on collateral of assets. As such, since these assets are constantly market to market, the leverage has to be adjusted for lending and borrowing. The cases are totally different in the bear and bull market. In the former, the increase in asset price leads to reduced leverage, while in the latter, increase in asset price leads to widened balance sheets. In completion, it has been observed that the asset money created by these institutions is greater than leveraging by banks. As such, the role in financial intermediation is huge and contributes large for the improvement of the financial market.
Bibliography and Citations
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